EUROPEAN STOCKS
Cherchez le Return
Cheap and chic: European stocks may offer U.S. investors a sweet deal.
FORTUNE
Monday, February 18, 2002
By Julia Boorstin
For years market strategists have been forecasting that European stocks were going to take off and leave U.S. equities in the dust. Good thing we weren't holding our breath: U.S. stocks have beaten their counterparts across the pond in seven of the past ten years. Now the promising prognostications are back. Lehman Brothers' chief global strategist, Joseph Rooney, for one, expects the continental European equity markets to outrun American stocks by ten to 15 percentage points--not accounting for possible currency gains. This time such optimism may be worth listening to.
The real selling point is price. The average price/earnings ratio on large-cap European stocks--both on a trailing and a forward basis--has dropped, while the multiple of the S&P 500 has shot higher. American equities now sport an average trailing P/E of 33.3, compared with just 18.9 for companies in the 12 eurozone countries. Why the big gap? According to Rooney, while expectations for a domestic economic recovery have been factored into U.S. share prices, European investors are more skeptical of a turnaround and have yet to rush into stocks.
That leaves some room for appreciation. Rooney thinks both economies will recover at roughly the same time, giving stocks on the eastern end of the Atlantic the lift their American cousins have already enjoyed.
A number of elements are helping foster this recovery, starting with the much ballyhooed debut of the euro. Standardization, the argument goes, will force European companies to become more competitive and efficient."The pressure from a single currency is a major catalyst," says Ian Harnett, head of European strategy for UBS Warburg. The increased cross-border competition, he says, will further fuel the wave of consolidation that has already begun, forcing companies to"rise, go bust, or merge."
Add to that the low-inflation, low-interest-rate policies fostered by the euro's keeper, the European Central Bank. The ECB has certainly been less aggressive than the Fed in cutting short-term interest rates. Still, with the equivalent of the U.S. discount rate at 2.25%, rates are low enough to encourage companies to borrow and to make equities look like a happy alternative to fixed-income investments. (And there's room for them to move even lower.) Typically, European investors have shied away from stocks, buying bonds instead. But that could change. Leila Heckman, global asset allocation analyst at Salomon Smith Barney in New York, says lower interest rates will encourage individuals to look to equities, which historically have offered a heftier payback than fixed-income investments. That could pump fresh liquidity into the markets.
Even some of Europe's notorious barriers to business--namely, high taxes and strict labor laws--have begun to come down. Take Germany, the EU's largest economy: In 2001 the corporate tax rate was cut from 45% to 25%; in 2002 the capital gains tax of roughly 50% was abolished. Says Rolf Elgeti, a European securities strategist at Commerzbank:"This changes the German tax environment overnight from one of the least attractive to one of the more attractive."
And you can't forget the currency issue. The euro has been hovering around 90 cents, and while there's no guarantee that it will shoot up against the dollar right now, most observers expect it to rise eventually."I think everybody accepts the fact that the euro is undervalued," Heckman says."Looking at its purchasing power, the currencies of its trading partners, and relative inflation rates, it appears to be trading lower than it should." A rising euro would be an extra bonus for a dollar-based investor.
Of course, there are myriad European companies listed in the U.S. But for a broad market play, the best bet is a low-fee exchange-traded fund. To track Continental Europe, Morningstar's Chris Trauslen recommends iShares S&P Europe 350 Index (IEV) or the iShares MSCI EU Monetary Union Index (EZU). Low-cost index mutual funds are also a good option. Bridget Hughes, a Morningstar international fund analyst, recommends Vanguard European Stock Index (VEURX) for a safe swath of European blue chips and suggests balancing it with a small- or mid-cap Europe fund, like AIM European Small Company (ESMAX).
With prices low and the potential for profits large, a little European exposure could add a certain je ne sais quoi to a wobbly U.S. portfolio.
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